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The hidden pitfalls of being tempted by leverage

Commentary: Long-term results of leveraged ETFs can be skewed

By

J.J.Zhang

Columnist

J.J. Zhang is a chemical engineer and amateur financial adviser who was the winner in MarketWatch’s second annual World’s Next Great Investing Columnist contest. He runs the blog MarketTech Reports. You can follow him on Twitter @MarketTechRpts .

A common question for many investors is how to generate higher returns with the limited capital they possess. With the common belief that the market always goes up in the long term, the question of leverage naturally arise. After all, if over a 30-year time frame the market always goes up, why not leverage it?

Reuters

Leveraged ETFs may be tempting but they can be costly and long-term results can be skewed.

There are several ways leverage takes form such as with options or trading on margin but the downside risk to those are generally well known. With margin trading, investors know about the potential for margin calls and also the interest they pay. With options, investors know about time premiums and the high chances of ending out of the money or being on the losing side of a rally.

However, what’s a bit less obvious is leveraged ETFs. While leveraged ETFs have attracted significant regulatory scrutiny, which led to a moratorium on new entrants, several older funds are still available, a list of which can be found at ETF Database.

The two most popular leveraged ETFs are the ProShares UltraShort S&P 500
SDS, -0.11%
, which promises to deliver double the inverse daily performance of the S&P 500 and the ProShares Ultra S&P500
SSO, +0.11%
, which promises double the daily performance.

For many people, they may look like a great deal. If the stock market always go up over the long term, what could go wrong? In reality however, there are hazards inherent with leveraged ETFs beyond the typical equity-market risk that are not apparent to the average investor.

First, how do they work? In general, leveraged ETFs promise to deliver a multiple of the underlying indices’ daily return (note the term daily). For the ProShares S&P 500 leveraged ETFs, these outsized return are accomplished using derivatives, mainly index swaps and futures, in addition to holding common stock.

As ETF Database explains:

For example, a 2x long S&P 500 ETF may use a combination of equities, futures and swaps to essentially double its exposure. A fund with $100 million in assets might invest $80 million in the underlying assets of the underlying benchmark, leaving $20 million in cash. A portion of this cash could be used to purchase S&P 500 futures contracts — exchange-traded derivatives that provided exposure to a benchmark without direct ownership. A futures contract is essentially a standardized contract between two parties that agree to buy (and sell) an underlying index at a future date at the market price.

In addition, a leveraged ETF may enter into an index swap agreement with a counterparty to increase its exposure to the underlying index. Swaps are customized agreements between two counterparties to exchange two sets of cash flows over a specified period of time. In an equity index swap, one party generally pays cash equal to the total return on the underlying index, while the other pays a floating interest rate.

High expenses

One effect of this derivative usage, and the constant derivative rebalancing, is a high expense ratio. SSO has an expense ratio of 0.91% and its short twin SDS is at 0.89%, much higher than the S&P 500 ETF
SPY, +0.06%
of 0.09%. Such a high expense alone makes it poorly suitable as a long-term investment.

The high expense may be forgiven if its leveraged performance truly sings. However, long-term leveraged performance is a somewhat mixed bag.

From a daily performance standpoint, SSO and SDS generally do a good job meeting their goals of 2x long and inverse returns vs. the S&P 500. Over a 60-trading-day period, the 2x long ETF SSO averaged a daily performance that was 1.97x the S&P 500. The 2x inverse ETF SDS averaged a daily performance of -1.99x SPY, quite close to the promised goals.

Perhaps the biggest hidden nuance with leveraged ETFs is that doubled daily returns don’t lead to doubled long-term returns. The math is relatively simple, if you’re starting with $100, a 10% gain on Day 1 results in $110. A 10% drop the next day ends you at $99 due to the higher starting base on the second day. Double the daily performance however and you’ll end up at $120 on the first day and $96 on the second, 3% lower than the non-doubled benchmark.

For super leveraged 3x ETFs, the effects are even more amplified with results of $130 and $91, an 8% drop vs. the benchmark.

On the flip side, if the benchmark gains consistently, the higher daily starting base also juices the performance a bit. Using a hypothetical situation of three consecutive daily gains at 10% each, the benchmark would increase to $133 at the end while a 2x ETF would be up to $173 and a 3x ETF would be up to $220, much higher than the $166 and $199 that would represent a perfect doubling or tripling.

Tracking error

This long-term tracking error does show up in real-life performance. While the S&P 500 is up approximately 19.5% for the year, the 2x ETF is up 40.3% and the 3x ETF up 64.5% while the 2x inverse ETF is down 31.8% and the 3x inverse is down 44.3% — none of them a perfect multiple.

While the daily movements in the examples are exaggerated, the same effect will happen at normal market changes at a lesser degree. Extreme volatility can wreak havoc on leveraged ETF long-term returns. In many cases, particularly for the 3x inverse ETFs, even if the underlying index moves in the anticipated direction, you might still end up with a loss.

The nuanced and volatile returns for leveraged ETFs dictate the need for constant monitoring of their performance, something few retail investors can or should do. It also reinforces the fact that these should be short-term vehicles with a slight speculative streak as opposed to reliable and predictable long-term investments.

J.J.
Zhang

J.J. Zhang is chemical engineer and amateur financial adviser who was the winner in MarketWatch’s second annual World’s Next Great Investing Columnist contest. He runs the blog MarketTech Reports. You can follow him on Twitter @MarketTechRpts.

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J.J.
Zhang

J.J. Zhang is chemical engineer and amateur financial adviser who was the winner in MarketWatch’s second annual World’s Next Great Investing Columnist contest. He runs the blog MarketTech Reports. You can follow him on Twitter @MarketTechRpts.

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